Saturday, 11 October 2008

Why Worry About China?

I was reading a brochure for a futures conference this week when I came across an extraordinary statement. One of the presenters claimed that “China’s GDP could overtake America’s as early as 2015”. This stopped me in my tracks. The claim seems so wild that I just had to investigate the basis on which the statement might become true. It may be true that China’s economy is growing very fast, but it is growing from a very small base and that the US economy, relatively speaking, is huge. I thought that I would look into this prediction.

According to The Economist, in 2007 America’s GDP was $12.4 trillion whilst that of China was $2.2 trillion. This century, America’s GDP has been growing at an average rate of 4.5% per annum, whilst that of China has been growing at 12.9% per annum. If the US continues to grow at an average of 4.5% per annum, then China’s economy would have to grow by 28% per annum in order to reach parity by 2015. Equally, if China’s GDP continues to grow at 12.9% each year, then the US economy would have to shrink by 8% a year in order for parity to be reached by 2015. On this basis, we are more likely to be hit by an asteroid than China’s GDP overtaking that of the US by 2015.

This does beg the question of when, if at all, the GDP of China would overtake that of the US. It would depend upon the growth assumptions we make about the two economies. We put together a small econometric model to examine the implications of differing growth rates. For the US, we assumed growth of 0.0% pa (the zombie economy), 2.0% pa (the US achieves European growth rates), 4.5% pa (the US stays on track), and 6.0% pa (a miracle occurs). For China, we assumed growth rates of 4.5% pa (China achieves US growth rates), 8.0% pa (the expected rate after 2014 when the Chinese demographic time bomb explodes), 12.9% pa (China stays on track), and 15% pa (a miracle occurs).

Running the 16 pairs of possibilities (you could say the 16 scenarios), we obtained the following results:

The date in each of the cells is the point in time when Chinese GDP overtakes that of the US in our model. The results highlight two interesting points. First, when Goldman Sachs famously predicted that the GDP of China would overtake that of the US by 2025, their model was assuming average US growth rates of between 2.0% pa and 4.5% pa. More importantly, Chinese growth rates were assumed to average between 12.9% and 15.0% pa. This latter assumption seemed heroic at the time and seems even more so today.

The second point of interest is the amount of time that it would take for Chinese GDP to overtake that of the US if the US maintained or upped its game or if the Chinese game came off the boil. We are looking at a “not in my lifetime” series of results. This is not to say that we ought not to look at them, but it is to say that the contention of China overtaking the US does need to be treated with a high degree of scepticism. After all, who is to say that China, as a political entity, will last until 2040 or 2050?

Obviously the current downturn is going to affect the numbers that we used. There are also a number of additional flaws in the model. To start with, it is a linear model in a non-linear world. We also presumed a low degree of multi-collinearity. This is unlikely to be the case as both the US and the Chinese economies are highly interdependent. For example, this year, US GDP growth has fallen to zero (or less). As a consequence, China’s GDP growth has fallen to 10% (and falling, and subject to downward revision). However, even with a flawed model, we can see that the forecast of 2015 as the point where China’s GDP overtakes America’s GDP is nothing more than a wild dream.

If it is the case that China is unlikely to overtake America, then why do we worry about China?

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13 comments:

Stephen, great post. The base forecast of Barry Hughes' IF model has China surpassing the U.S. by 2050, with India surpassing China by the 2070s. But isn't GDP just a gross measure, isn't GDPPC, per capita a more telling factor? I always enjoy your insights.

The significant point is not really the timing, but the steady reduction in the difference in global economic clout, and the shift in power that this brings. The fact is that the US has 0.3 bilion people, and China and India combined have about 2.5 billion. Inevitably, at some point in time the locus of economic power will shift back to the east, and already has to a strong degree.

With thta shift in economic power will be shifts in political and philosophical space. What kind of power will China be in 2050, if that is given as the approximate time it overtakes the US as biggest economy? What will happen in terms of possible clashes of values? There are already philosophical clashes, as any cursory stop on any public web site visited by Chinese netizens will show. Chinese tend to be hyper-nationalist, aggressive and blame the west for just about everything, including their country's fall from power (in fact the seeds of the decline of China, and the rise of Europe, were planted long before the Opium wars and such). This blame game was initiated by the government for political purposes, to distract the people from the fact that Mao ruled over the single most destructive regime in the history of the planet. Now the thing has taken on a life of its own, an blame and victimhood are seemingly compulsory in any debate involving mainland Chinese people.

Interestingly, China, like the Islamic countries, declined because there was no public space for business to flourish, the legal system did not encourage individual and institutional power, and society was too rigid and hierarchical, not allowing freedom of thought and deep questioning. Interestingly, these things are delimited to some degree even today in China (but not nearly as much). But the current "Communist" government my have to cede more power and control in order for some kind of knowledge economy to develop.

The other question is how well China is equipped to come through the current global economic crisis. It's a manufacturing economy, with limited development of service and information sectors. It could be in trouble, despite massive reserves of currency.

In short , there are many unknowns with China. I wouldn’t like to place all my eggs in that basket.

The other thing which raises concerns with China - and I can say this after years living in the region - is that the Chinese are masters at window dressing. They are champions at hiding the dirty bits, and polishing up the stuff on public display. This is more than a simple Communist trait (you saw it in N. Korea, and with the USSR, E. Germany etc.). It's deeply cultural. In schools on parents’ day, schools display the kids’ homework - but much of it has been done by the teachers! i.e. the issue goes right through society, this culture of deception. People visited China in the early 1960s, and came back the west with glowing reports of China's great progress. Little did they know that China had just experienced the greatest man-made catastrophe in the history of human civilization - 30-50 million dead during the so-called Great Leap Forward. The Communist party covered it up, which is some feat!

This culture continues to this day. If I cross the border from Hong Kong to Shenzhen, I am immediately hounded by beggars, pimps and madams, prostitutes, shoe polishers and fake DVD sellers. They exist in Beijing too. But for the recent Olympics, all these people were removed from the city, along with the migrant workers who built the city, because their dirty, unkempt, low-class faces were not the kind of image Beijing wanted the world to see. There are 700 million peasants in China, and 45% of them are so poor that they cannot afford to see a doctor if they get sick. Meanwhile they are sending men on space-walks.

Again, to summarise, there is a danger both for the Chinese people themselves, and for observers, to become deluded by this culture of deception. It's fine to put your best foot forward, but there is danger that self-delusion can lead to a big fall. That is what happened during the Great Leap Forward, and because all discussion of that time has been erased from China's history books and media discussion, the lessons of that time have not been learned. This worries me more than a little. I'd hate to see china go down again, but history shows that major social calamity in China is never more than a few decades away.

Also, China is undergoing a new statistical census. If the numbers match the city and regional numbers then the national GDP growth could be underestimating the GDP by 3-4% per year as it did in the last statistical census.

In 2008 and 2009, it looks like the US is heading for zero to negative 2-3% growth and China is going to 8-9%.

If you are using the naked dollar approach then you need to have a projected exchange rate.

The yuan has appreciated 17% since 2005.

The US$ has fallen from 0.83 cents to the Euro to 1.36 (as high as 1.6) dollars to the Euro from 2000 to now.

Why do you project no appreciation for the yuan against the US $ out to 2050 ?

You are assuming that the 2007 Economist figures are correct. The last Chinese economic census adjusted its GDP estimate up by 17%. There are performing another one which the Economist indicates could adjust china's GDP up by 1.2% per year or 6-7%.

Personally, I am more worried for China than about her. High growth and expanded prosperity would increasingly empower her middle class and nudge the society towards liberty. But there seems to be much in the way of economic reforms that are not being done and even some backsliding.

Tha exchange rate is one price among many (i.e. the price of dollars in yuan, and vice-versa). If we included the issue of relative prices (exchange rates, interest rates, the terms of trade, etc.) then the model would have far more detail than we needed for this simple exercise.

You are right, we could add more detail, to the model, but I'm not sure that we would have had that better results for doing so.

Exchange rate is fundamental to this analysis of when China's economy passes the US economy on a nominal or exchange rate basis. Japan's yen increased almost 400% from 1970 to now. The main currency increase period was during its GDP per capita catch up phase.

In 2008, one year from your one data point. China's economy is $3.95 trillion [not including Hong Kong and Macau] versus the US $14.3 trillion. Based on your model China should be at $2.8 trillion. $14.3 * (2.2/12.4) * 1.1 [faster growth]. So your "model" is already over 40% too low for China or 4-6 years too slow.

The Economist, your source, projects China's currency to go to 6.25 by 2013 and the US to have no growth this year and next year and 2.5% 2010-2013.

I do not understand what the purpose of having such an incredibly wrong projection is. Using a model like this, I could project the earnings of a college graduate now for 2050 but ignore inflation.

I am willing to put who is more correct on this matter to a bet.I bet that China's nominal GDP will pass Japan's by the end of 2011 and will be over half of the US GDP by the end of 2013 and China's GDP including Hong Kong and Macau will pass the USA by the end of 2021. The statistics used ban those in the Economist or the Economist Intelligence Unit.

I "straight line" the average change of 2000 through 2004 and then average change from 2004 to 2008. I look at the actual nominal dollar values from each of those years. So there is actual historical all in change. 2000-2004 had stable currency exchange rate. Like technical analysis for stocks, looking at the numbers.

In the comments to the article I have laid out the fundamentals case for why China is in a continuing strong growth position.

Well, it's almost a year on, and how things have changed in that time. Much of the comment around the original post focussed on two areas:1. The Dollar/ Yuan exchange rate. This has been a managed rate for some time, and is likely to remain so for some years to come. This rather undermines the 'terms of trade' argument, which relies on freely adjusting exchange rates.2. The argument about China surpassing the US by 2020 and doubling the US by 2030 seems even more fanciful. This argument did not adequately consider the Chinese demographic time bomb (due to detonate in the next decade) and failed to acknowledge the impact of long term productivity differentials.So where are we today? It still seems that tales of China surpassing the US are pretty fanciful.

Now China has accounting revisions and another business census adjustment. China including Hong Kong and Macua is over 70% in 2014 and will be about 75% in 2015. Modest 2% annual currency strengthening and 4% annual advantage in GDP growth and another 2019 business census should have China passing in 2019. China already passed the US with PPP in 2014.